Wednesday, November 26, 2008

Brown and TARP: Are they perpetuating the mess we're in?

Applauded and replicated around the world for its decisiveness and firm action, the Brown Plan for financial system revival is proving to be seriously flawed in three major respects.

First, Brown recapitalised the banking system before we established what the toxic assets residing in the system were worth. Despite a first expensive round of bank recapitalisation we still do not know how much more capital is needed to cope with toxic assets being written down to 'fair value'. That was what the US 'Troubled Assets Recovery Programme (TARP) was to do. Unfortunately, Congress took some time to pass TARP legislation. The anxiety that created, emboldened Brown to steal the US' thunder and come up with an alternative plan for recapitalising banks, to alleviate global public concern about their solvency.

Predictably, that move started a wave of competitive recapitalisations; leaving the US in danger of a massive shift in global deposits from American to non-American banks. To prevent a debacle, the Fed-UST followed suit and went for premature recapitalisations in the US as well, using the US$700 bn for a different purpose to that for which it was originally approved.

Sadly, Brown jettisoned the reverse auction and asset reconstruction (ARC) features of TARP. These two mechanisms were indispensable. An ARC would have bought toxic assets at a discount and accumulated them in one place. That would have allowed them to be de-synthesised and re-bundled into more appropriate packages with more transparent risks. In other words, an ARC could have separated out sub-prime loans made to immigrant gardeners, from better quality loans to multiplexes, shopping malls, and office buildings. That would have allowed toxic assets to be rearranged, revalued and repriced more acceptably.

Eventually such transformed assets would have been sold back in financial markets at prices resulting in a profit for theARC on the spread between discounts at which they were bought and later sold. But, the speed with which the Brown Plan was replicated globally prevented this essential purgative from working. As a consequence, we are now left with toxic assets still on the books of global banks. They are perpetuating everyone's concerns, not least those of the banks themselves, about the credibility of their balance sheets and their 'real' solvency. That is continuing to impede inter-bank trust and unsecured interbank lending for all purposes including trade credit which is drying up.

To illustrate, the aggregate amount of toxic assets remaining on bank books are estimated to be around US$3 trillion. The fire-sale price at which Merrill Lynch sold its toxic book before being taken over by BoA was US$0.22. No one else wanted to sell at that price. Using the usual mathematics, these assets are unlikely to be worth more than US$0.67. But the range of 22-67 US cents is too large for bank managements, regulators, rating agencies or auditors to arrive at a consensus on fair value. At the fire-sale floor price these assets would be worth US$660 billion. That would result in a loss of US$2.34 trillion requiring an equivalent capital write-down for the system. About US$1 trillion has already been written down. A fire-sale price would therefore create further capital funding requirements of $1.34 trillion. On the other hand, at the 67 cents ceiling of that range, the assets would be worth US$2 trillion resulting in a loss of US$1 trillion. That would give much more comfort about the solvency of banks. The reality probably lies somewhere between those limits (45-50 US cents?) which would still create a requirement for a further $500 billion or so in new capital requirements.

To make matters worse, however, even the prime assets of global banks are now becoming shaky as the recession bites. That is increasing NPAs and provisioning as well as write-down requirements,necessitating a second round of capital fortification of an unknown amount. It will accentuate uncertainty on the part of bank managements about how much more risk can be taken by lending in a downturn when household and corporate cash flows are worsening. That will defeat the intent of the recapitalisation exercise: i.e. to get credit flowing easily again.

Second, in providing national guarantees to get banks to lend to one another again in the global unsecured interbank money market, Brown made a cardinal error. The interbank market is a global seamless market in which the largest participants are not just banks,but money market funds, and other holders of cash liquidity such as large corporate treasuries, acceptance houses, pension funds,insurance companies etc. It is not just a national or banking market. National guarantees are a sub-optimal device to get that market working again. They may unblock British banks from lending to one another in London. But they will not unblock them from lending to non-British banks knowing they are not guaranteed.

Even if understandings are such that British banks are comfortable about lending to EU, US and Japanese banks, because of guarantees provided by those other governments, they are still taking unknown risks by lending to non-EU, non-US and non-Japanese banks (i.e. ASEAN, Indian, Chinese, Brazilian, Middle Eastern, African banks etc.). That is the prime reason trade financing in these regions is drying up. Banks around the world are no longer prepared to accept cross-border LCs, packing credits, bills of exchange, import and export credits that involve an uncovered risk. National guarantees need to be pooled and triggered by an international authority to makethe global interbank market work properly again. The world's central banks need to develop instruments enabling them to operate directly in these markets to restore confidence, and make risks in these markets more acceptable, rather than just keep infusing liquidity through banks against any form of collateral. It is not just liquidity that is the problem. It is the continuing lack of confidence within the banking system.

Third, Brown did not address the critical issue of the uncertainty overhang in the credit default swap (CDS) market which restrains banks from lending because of uncertainty about counter-party credit risk at a time of extreme uncertainty. That risk is changing daily. The pricing of CDS' reflects that. Global central banks and regulatory authorities need to get together immediately to create a central clearing corporation for CDS. Outstanding US$33trillion worth of CDS contracts (US$ 3.3 trillion after netting out) identified by the DTCC should be handled by the CCC acting as counterparty to each side of every bilateral OTC deal. Eventually such contracts should be priced and traded on exchanges. Though this seems complex, it can be done more easily than imagined. Unless the CDS market unfreezes quickly it will continue to act as a brake on credit flows no matter how much liquidity is created.

Haste always makes waste. Trying to be too-clever-by-half (a fundamental failing in Brown's psychological make-up that reveals itself every time a crucial juncture is reached) results in his ending up looking daft. Just a month after the Brown Plan was unveiled and propagated it is becoming apparent how half-baked it was. It put a band-aid on an open wound that is still festering. Is it any wonder then that, despite a sense of brief respite after its arrival, the mood has reverted to one of despair, doom and gloom?

Perhaps the market -- in still trying to find that elusive bottom-- is signalling something we are not sufficiently sensitive to. It may be signalling that, despite everything that has been done so far,the market has no intrinsic faith in political leadership anywhere; particularly in the US, UK, EU and Japan. While everyone is looking to governments to prevent collapse and solve the problem, no one has any faith in the political pygmies presently running them. Will the incoming Obama Administration make a difference? One can but hope.

The market has certainly lost faith in banking leadership; India being no exception. It is now losing faith in industrial leadership to put things right. Yesterday's masters of the universe, whether bankers or industrialists, are today's nervous breakdowns. They are asking forhelp of every sort from every government, to cover up for poor strategic decisions and failed business models, without realising what their demands are adding up to. Governments in a panic seem willing to oblige them, regardless of future consequences. Their actions are having unintended consequences (like the USD appreciating when it should be depreciating) that will continue to delay the kind of global adjustment that is so necessary to put this debacle behind us in a decisive fashion.

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